Inflation Bonds Tip the Scale

Here's a tip: Don't expect TIPS funds to take flight just because inflation is finally showing up in the official data.

A pair of reports last week from the Institute for Supply Management may have shown contrasting results -- the services index plummeted in September, while manufacturing rose -- but they did share rapidly rising inflation gauges.

In the manufacturing survey, the prices paid index surged from 62.5 in August to 78 in September. In the service sector index, the prices paid index jumped from 67.1 to 81.4, which was the index's highest reading since it was created in 1997.

The idea that inflation is rearing its ugly head is hardly a shocker. Americans have spent the year steadily watching their purchasing power erode in every place except Wal-Mart ( WMT), where most of the goods arrive on fast boats from China.

What they have not seen, however, is a marked step-up of inflation in the official data -- a conundrum that may rank second only to Fed chief Alan Greenspan's mystery of the flattening yield curve.

That riddle could very well be solved as early as Friday, when the September consumer price index is released. Economists are expecting a dramatic increase to 0.9%, up from 0.5% growth in August. Some are predicting even bigger jumps down the road as higher energy prices are finally pushed onto the consumer.

"We have seen the CPI creep up lately, but over the next few months it is poised to really take off," says John Silvia, chief economist at Wachovia, who adds that that the big gains in the CPI will be presaged by spikes in the producer price index.

Under these circumstances, it would seem like Treasury Inflation Protected Securities, or TIPS, funds would emerge as the perfect investment. They are designed to protect investors from the erosion of purchasing power that rising inflation can cause.

In an inflationary environment, TIPS, which pay a semiannual coupon, tend to outperform most traditional fixed-income investments because their par value is adjusted to account for changes in the CPI. For instance, if the CPI rises by 0.7%, the value of the TIPS bond would also climb by 0.7%. If the CPI were to decline, the bond's value would fall very little because the government guarantees the original investment.

Unfortunately, the recent performance of TIPS has not followed the conventional wisdom. The iShares Lehman TIPS Bond ( TIP) exchange-traded fund, for example, has fallen close to 2% since the start of October, just as inflationary pressures are finally hitting the headlines.

Furthermore, the break-even rate, which in bond parlance is the difference between the yield on conventional Treasury securities and that of comparable TIPS, has declined on the 10-year note from 2.58 percentage points at the end of September to 2.45 percentage points. A tightening spread signifies TIPS are lessening in value relative to normal Treasury bonds.

According to Ken Volpert, portfolio manager of the $9.1 billion ( VIPSX) Vanguard Inflation-Protected Securities fund, part of the problem for TIPS prices is a burst of new supply hitting the market this month. The more pressing difficulty, says Volpert, is the recent spate of "tough inflation talk by a host of Fed governors."

Last week, Kansas City Fed President Thomas Hoenig reiterated the view that inflation remained enemy No. 1 for the central bank. And in a speech last Thursday, Dallas Fed President Richard Fisher referred to inflation as a "virus" that cannot be allowed to "poison the system" as it did in the 1970s.

"There is no doubt that the Fed is getting aggressive and the market is responding," says John Brynjolfsson, portfolio manager for the $11 billion ( PCRDX) Pimco Commodity Real Return fund, which combines TIPS and derivatives to mimic the performance of the Dow Jones-AIG Commodity Index.

Fund managers say Fed vigilance has the power to depress TIPS prices for as long as the governors keep up the pressure. Nevertheless, a number of TIPS fund managers don't expect the Fed to win the war on inflation, even if it has been victorious in recent battles.

"As the Fed takes a more aggressive stance on inflation it will be a countervailing force for TIPS, especially at longer maturities," says Clifton Rowe, portfolio manager for the $9 million ( LSGSX) Loomis Sayles Inflation Protected Securities fund. "But we expect some scary headline CPI numbers over the next few months that will certainly grab the market's attention and boost TIPS in the long run."

Brynjolfsson attributes the recent selloff to a mentality that he says began with hurricanes Katrina and Rita.

"The TIPS market reacts to expectations, and after Katrina you saw TIPS rise both on an absolute basis and relative to nominal bonds," says Brynjolfsson. "That reversed quickly after it was established that oil supplies would not be hindered due to downed refineries and the recognition that the economy would not crater after Rita."

"Most recently, there has been a rumor that the CPI will print close to 1% this week, and now that has become the de facto way of thinking," says Brynjolfsson. "So now they are asking not what happens over the next month, but over the next few years. And that's up to the Fed."

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